Market Fragility Index: A New Economic Indicator

The Market Fragility Index presents a look at how “out of whack” the stock market is compared to the rest of the economy as well as how big the cracks are in the foundation of the economy.

Before defining the new index, one may need a primer to understand exactly which metrics it is composed of.

GPD and Stock Market Capitalization

Gross Domestic Product (GDP) is the total size, or value, of the economy.

Stock market capitalization is the total size, or value, of the stock market.

When these two figures are plotted, like in the graph below, one may notice a few things.

The overall size of the US economy has generally always been on the up and up. The United States has continually increased its economic output (albeit a few exceptions).

The stock market’s value always flows up and down – a characteristic of the Keynesian style of economics within the US. These are the booms and busts of the economy manipulated via monetary and fiscal policies; as well as natural and man-made disasters i.e. hurricanes and war, respectively.

The last two greatest recessions in recent past, the tech bubble popping in the early 2000s and the Great Recession of 2007/2008, occurred when the stock market was heavily overvalued.

There is no reason the stock market should be so dramatically overvalued compared to the economic output of the United States. To give a better representation of these two metrics, enter the Buffett Indicator.

The Buffett Indicator

Warren Buffett, the most famous and one of the world’s wealthiest men, became so simply by investing. He has claimed that one of the best ways to know if the market is overvalued or undervalued is to look at the ratio of the stock market capitalization to the GDP (presented below).

According to Buffett, a ratio of 70% to 80% often presents a buying opportunity, while a ratio moving above 100% indicates a correction could be in store in the near future. [1]

If one were to divide the stock market capitalization for a given quarter by the same quarter’s GDP, it would yield the percentage corresponding to the Buffett Indicator. Notice that Buffett’s 80% threshold seems to hold true in that once that threshold is crossed, it is time to lay off buying and perhaps look for a good selling point to exit the market.

(Stock Market Capitalization) / (GDP) = %

Historically, each time the Buffett Indicator has surpassed the 100% threshold there has inevitably been a crash; and within this past decade, the US has ventured dangerously far into uncharted territory. This indicator simply demonstrates that many of the individual stocks are overvalued and seemingly are in a bubble. This makes the stock market top-heavy compared to the rest of the economy.

Margin Debt

Put simply, margin is leverage within the stock market; the ability to buy more stock than one can afford.

Example: One opens up a trading account and the brokerage house may let that person borrow against the funds deposited. Meaning, one may put 20% down and they could buy 5 times more stock than that person could afford; yielding a 5-to-1 leverage. If the stock goes up 10%, that person would make 50%. And if the stock goes down 10%, that person would lose 50%.

The above example can be exacerbated once the inner trading-houses of the banks and brokerages start to get involved. What many banks do is leverage people’s deposits for their own gain. Consequently, these brokerages receive better margin rates in that they can leverage much more than typical traders because “they know what they are doing.”

Example: Lehman Brothers was leveraged 30-to-1 before they went belly up, triggering the global financial crisis of 2008. This means that they only needed to put 3% down; but, if their investments went down just 3.3%, they were completely wiped out. And that is exactly what happened.

So why is all of this margin debt talk important? Isn’t what happened in 2008 in the rear-view and since been fixed? Well, the long and short of it is no. Though it is not an “end-all, be-all” indicator to the health of an economy, it is important to understand what it is. Additionally, it is part of the vulnerability index soon to be explained.

Opt-Out of Margin?

In the past, when someone wanted to open a trading account with a brokerage firm, that person had to qualify and opt-in for the ability to add and use margin within their account. That ensured that the person understood the full risk in using margin and had the funds/means to pay the debt back if that person made a bad trade.

In today’s world, however, that seems to no longer be the case. One is seemingly automatically qualified for margin, short-selling, etc. Furthermore, the applicant is no longer presented with the risks entailed by margin and are forced to seek education elsewhere. This means that more people have the ability to use debt to purchase stocks in record number without fully understanding the repercussions of doing so.

And what repercussions would those be? Well, depending on how bad a trade was, that person’s auto, house, savings/checking/retirement accounts, etc. could be subject to confiscation in order to pay the debt. They have the right to take all of the above from someone until the debt is repaid because that person was gambling. So these brokerages are now encouraging this type of behavior. Despicable.

The Numbers

From the graph below, it is easy to see that investors, consumers and banks alike, have not learned their lesson. Margin debt is at an all-time high – nearly 1.5-times what it was at the peak of the Great Recession.

Margin Debt to GDP Ratio

Sometimes people like to view margin debt as a percentage to GDP (given below). Again, one can see that this percentage has never been higher. The fact that margin debt is valued at nearly 3% of US GDP is quite mind-blowing.

Margin Debt and Real Growth

Another relationship with margin debt is when it is compared to the “Real Growth” of the economy as shown by Advisor Perspectives (below). [3]

The next chart shows the percentage growth of the two data series from the same 1997 starting date, again based on real (inflation-adjusted) data. We’ve added markers to show the precise monthly values and added callouts to show the month. Margin debt grew at a rate comparable to the market from 1997 to late summer of 2000 before soaring into the stratosphere. The two synchronized in their rate of contraction in early 2001. But with recovery after the Tech Crash, margin debt gradually returned to a growth rate closer to its former self in the second half of the 1990s rather than the more restrained real growth of the S&P 500. But by September of 2006, margin again went ballistic. It finally peaked in the summer of 2007, about three months before the market.

To Advisor Perspective’s credit, they share the same conclusion about margin debt. That it is important and may be a “leading indicator” to ascertain fallacies within the economic market, but the metric cannot be read in real-time (meaning it is published weeks old) and is simply not reliable enough [3]:

Margin debt data is several weeks old when it is published. Thus, even though it may, in theory, be a leading indicator, a major shift in margin debt isn’t immediately evident. Nevertheless, we see that the troughs in the monthly net credit balance preceded peaks in the monthly S&P 500 closes by six months in 2000 and four months in 2007. The most recent S&P 500 correction greater than 15% was the 19.39% selloff in 2011 from April 29th to October 3rd. Investor Credit saw a negative extreme in March 2011.

Margin Debt to Stock Market Capitalization

Mike Maloney was interested in the percentage of margin debt there was relative to the stock market capitalization value. One can see that this relationship peaked during the Great Recession around the 2.25% mark.

It is guessed many will say, “2%? That’s nothing.” But one must remember, that even if consumer margin debt is ignored, the banks are the real players at the table. The typical investor has maybe 5-times leverage; whereas the typical bank has 20-times leverage (conservatively).

This means, that in the worst case scenario if brokerage houses held all of the margin debt, that could be nearly 40% of the stock market. Could one imagine? A stock market valuation with nearly 40% consisting of debt – err gambling. Again, that is the worst case scenario, but these are conservative numbers as well (remember, Lehman Brothers were 30+ times leveraged) and it is true that banks/brokerage firms hold the majority of margin debt.

However, that does not give the typical investors a pass. It is because of novice investors and the automatically added margin to brokerage trading accounts that exacerbate this problem. Unlike managers who use hard numbers and facts to make their decisions, novice traders are simply gambling (in every sense of the word) in the “high times” of the market; the emotions of greed and fear. This could mean that in the next crash (or major correction) those brokerages are going to be taking a lot of cars, homes, and other accounts.

As an analyst, Maloney noted that because the range of this graph was approximately [0.7%, 2.25%], that it would make a great multiplier to a previous relationship to better incorporate these three discussed metrics (GDP, stock market capitalization, and margin) to arrive at what he has deemed the Market Fragility Index. [2][4]

Market Fragility Index

So what has been learned up until this point?

Individual stocks are in a bubble.

The stock market as a whole is overvalued. It is top-heavy compared to the rest of the economy.

Margin debt is a factor propping up the stock market. It is like cracks in the foundation of the stock market.

The Market Fragility Index is an attempt to weigh how top-heavy the stock market is and how big the cracks in the foundation are. As was noted earlier, the Buffett Indicator may indicate when the stock market is overvalued, but it fails to indicate how fragile and vulnerable it may be to a collapse. [5]

The Market Fragility Index combines the Buffett Indicator with margin debt. By combining these two crucial and telling inputs into one measure, it can indicate the magnitude and tenuousness of the stock market bubble. [5]

To better understand the index, Maloney included color-coded tier indicators.

It can be noted that the current stock market situation is seemingly the most fragile it has ever been in recent history. According to Maloney’s indicator, the stock market now presents a “threat to the global financial system” much like during the Great Recession and Tech Crash.

For some, this amount of historical data may not be enough as there are only 2 major peak-and-valley groups with another one emerging. Yet, every time the indicator has gotten this high, there was a severe financial, economic, and/or monetary crisis just around the bend. The stock market is “more fragile now than at any time in history. It’s not just top-heavy; the combined amount of leverage and lofty valuations we have today exceed even those of 1929.” [5]

While many will clamor “doom and gloom” or “the boy who cried wolf,” it very well may be. No one can predict the market with any degree of certainty other than to say a bust/crash/recession will happen – it’s simply the nature of the Keynesian style of economy the U.S. maintains. The current U.S. economy has been in its longest expansion in history and it cannot last forever.

It never hurts to prepare one’s self and family for a rainy day. It is better to be too early than too late. Protect the wealth one has worked so hard to attain and as always: stay informed.

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About Author

Jaise Donovan

Jaise is a conservative-libertarian who believes the sovereignty of the nation lies with "we the people" and not the government. He writes to inform others of the actions of government (or the people in it), to analyze possible outcomes of such actions, and bring to light important issues of the day. He tries to convey his thought process of how it can effect lives on a daily basis both politically and economically – for better or for worse.